Nick Timiraos reports,

some economists, together with policymakers at the White House and Federal Reserve, are warning that mortgage-lending standards have become too restrictive, years after carelessness by lenders inflating the housing bubble.

… the Urban Institute, a think tank in Washington, estimated that around 200,000 fewer mortgages were made in 2012 due to credit standards that were more stringent than they were before the housing bubble.

Don’t say that like it’s a bad thing!

In mortgage lending, a type I error is making a loan that defaults. A type II error is turning down a loan that would have been repaid. Some remarks.

1. When home prices rise, it very hard to make a type I error and very easy to make a type II error. If the house price has gone up, the borrower’s equity is presumably positive, and borrowers who get in trouble will sell their homes and pay off their loans.

2. During the bubble, Congress and HUD officials were convinced that lenders were making type II errors due to racial bias and anachronistic conservative lending standards.

3. After the crash, Congress and government officials were convinced that lenders had been making type I errors due to greed, predatory lending, and lack of regulatory oversight.

My own view is that lenders make type I errors and type II errors all the time. Still, I would rather have errors made by people for whom credit risk assessment is a profession, without the amateur meddling that comes from the political sector.

Nick Timiraos reports,

A consensus has emerged over the last few years among economists, academics, and industry officials that says any new system should do the following:

• Make the “implied” guarantee explicit and require any successors to Fannie and Freddie to pay a fee for that guarantee, as the chart up top illustrates. Successors would compete for business, selling securities and taking initial losses before any guarantee would be triggered.
• Get rid of those investment portfolios, or shrink them to the point where they don’t create systemic risks. This way, the firms wouldn’t be guaranteed by the government—only their securities.
• Require more capital and tighter regulation, since too little of both is what got Fannie and Freddie into trouble. Just how much capital will be required will be a major point of contention, because having more will protect taxpayers but would also raise borrowing costs.

As I have said before, what this “consensus” would accomplish is to complete the Wall Street takeover of the mortgage industry. The history is roughly as follows:

1. In the 1970s, Wall Street saw an opportunity to “disintermediate” the savings and loan industry, which formerly supplied mortgage loans. In a high-inflation economy, money market funds had a regulatory advantage for attracting funds (banks and S&Ls were constrained by regulatory limits on the interest that they were allowed to pay on deposits ceilings).

2. In the 1990s, with the savings and loan industry dead, Wall Street along with Freddie and Fannie took over the mortgage finance system. But Wall Street always resented having to work with Freddie and Fannie. See All the Devils are Here, by McLean and Nocera.

3. In the 2000s, Wall Street thought it had figured out a way to get around having to work with Freddie and Fannie. Investment bankers would issue “private label” mortgage securities, use the CDO structure to get most of these securities a AAA rating, and use those high ratings to substitute for the Freddie-Fannie guarantee. Wall Street firms managed to pull off this trick with a lot of subprime mortgages.

4. Then came the bust, which discredited the Wall Street model of securitization.

5. Now, what Wall Street wants is to re-start securitization. They realize that nobody will fall for the AAA-rating scam any more. They need a government guarantee. But they don’t want the government-guaranteed enterprise to take profits away from them the way that Freddie and Fannie did. Hence, the three items listed by Timiraos, particularly “get rid of the investment portfolios.”

Assuming that the “consensus” eventually becomes policy, the decks will have been completely cleared for mortgage finance in the United States to be a 100 percent shadow-banking enterprise, exactly what Wall Street wanted.

For me, this is painful to watch, even though for a long time I have realized that is the most likely scenario. It is like watching a young brat who wrecked the five-year old family sedan have his parents console him by buying him a brand-new sports car.

My suggested alternative to housing finance reform can be found here.

The Washington Post reports,

Five years after the federal government bailed out more than 1 million struggling homeowners, many who got the relief may end up losing their homes after all.

…The initiative was based on the flawed assumption that the economy would bounce back more quickly, undoing the damage wrought by plunging home prices and high unemployment.

No, the initiative was based on the flawed assumption that keeping people in homes that they should never have purchased in the first place was a good idea. At the time, I kept saying over and over that we should pay people’s moving expenses to get into rental units that they could afford.

These results are exactly what I predicted would happen. I remember complaining about setting people up to fail again when I testified at a Congressional hearing almost five years ago.

Remember that issue? I was on a panel here. I start about 18-1/2 minutes in.

Tony Sanders was in the audience and blogged about the panel.

1. On this post. Kebko writes,

Arnold, you have the causality backwards. The reason the standards for down payments were not reduced in the 1970′s is because the high monthly payments were the bottleneck for qualification. Reducing the down payment increases the monthly payment. But, in the 2000′s, the down payment was the bottleneck, so reducing the down payment at the expense of higher monthly payments was useful.

Comparing the two contexts, we should, in hindsight, expect that this would be an obvious paradigm shift between a high nominal rate environment and a low rate environment. The low down payments in the 2000′s are an effect, not the cause.

Certainly, reducing the down payment requirement does not cause market interest rates to be lower. So between those two variables, causality can run at most in one direction.

You are saying that the real estate industry is not going to push for lowering the down payment requirement in a high interest-rate environment. I can see that if the marginal homebuyer is low on income and low on assets. If nominal interest rates are high, the monthly payment will be daunting, and lowering the down payment requirement cannot help this person.

On the other hand, suppose that the marginal homebuyer has decent income and low assets. Even in a high interest-rate environment, lowering the down payment requirement might help that person. And if interest rates are high because of general inflation, including house price inflation, then from the bank’s point of view it is safer to lower the down payment requirement in this environment than in an environment of low inflation.

I think that the main reason that down payment requirements went down was because the people lending the money at least implicitly assumed rising house prices. In addition, government officials were beating up on lenders for rejecting applicants from what was called the “under-served” segment of the market. (Of course, by 2010, government officials described this segment as “borrowers who were not qualified” and were shocked, shocked that the evil, predatory lenders had forced these people to take loans that they could not repay.)

2. From a comment on my post on Shiller and Taleb,

Hi I am Taleb, honored to come here. The problem is more complicated. The class of proba distributions needed is restricted, so only thin-tailed ones are allowed. In other words, the law of large numbers operates too slowly to make a certain class of claims.

see:
http://www.fooledbyrandomness.com/FatTails.html